Friday, April 18, 2008

On the radio

I'm going to attempt to answer your original question and shy away from comments on Basel II's effectiveness as a regulatory accord, please forgive me but I know little about the specific risk measurement enhancements that it contains.

I know that the current situation, spurred by the subprime situation, was forecasted. It was forecasted by my professors at school, who warned about this very specific problem for my three years of Economics courses, and it was even known by our administration. Of course, I have no real hard evidence of the latter claim, but the very fact that they chose Ben Bernake to be our Chairman is interesting - Bernake's main work, throughout his entire life, has been on the Great Depression - its causes, the failed remedies, and the lessons learned. He is a pioneer in this field.

Many many economists pointed out the subprime situation, but also the general housing bubble and its historic proportions. And many economists, including my professors, made the link between securitized subprime bonds, their eventual bust, and the subsequent decline in home prices.

Almost everyone believed the subprime bonds would go bust and lead to a lot of losses. The main debate was a question of degree of losses. Many economists believed that, even if the subprime bonds went bust, it would not lead to a general decline in home prices nationwide. Their evidence for this? It never happened before - there has never been a national decline in home prices since the Fed started keeping track of home prices in the 1960s. That is, until today.

So, among Economists, it's not like this situation is a great surprise.

So how was the federal reserve to deal with such a situation in 2004? They could have easily raised interest rates out of concerns for all the leveraged loans and leveraged mortgages that were in existence. They could have easily instituted a regulatory regime, beyond mere paper records, for the OTC Derivatives market. Such a regime would have included close risk monitoring(I say this but the Fed clearly understood some risks in credit derivatives when they stepped in and started regulating it by mandating paper records), and people from the Fed even started warning about the interconnectedness of their securities and their sheer size, and thus the panic their implosion would cause. I think they should have started planning for an asset backed receivables exchange, like the new exchange being built in New Orleans. The best remedy however would have been a third party intermediary able to judge the credit worthiness of each party to adhere to the derivative contracts being traded. This would have had a similar effect as price controls, I believe, because if a CDS contract requires that one party pay up one billion if X company goes default, which is a somewhat normal number, well that is just ridiculous - but these kinds of risks were being taken.

So basically, what I think should of been instituted, and I would be real surprised if they didn't do this in the future, is an accurate measure of counter party risk calculated in terms of how much exposure they have to similar contracts. So if Lehman Brothers had 28 billion in CDS contracts - well that's their entire worth right, and the risk rating would of been very high, and then the Fed would say, hold on, these ten contracts could wipe out the entire bank, or at least make their reserve ratio illegal, and thus the "rating agency" would raise a red flag and cause the fed to investigate and approach the banks with their conclusions.

And I dont think the monitoring of these types of securities is really outside of the Fed(or another rating agencies) control. These derivative markets are big, but there are few players, much much fewer players than the public markets, yet the public markets seem to get regulated fairly well - people go to jail for all sorts of fraud and insider trading and what not.

This solution looks good on the surface but the problem that arises are the bond insurers. The bond insurers insured bonds(if something went bust, and the counterparty cant pay, we will!). But these bond insurers were totally unregulated as well - the were on the surface regulated by the rating agencies but underneath they were woefully undercapitalized for the task they were going to take on - and this is the fault of the rating agencies, not the federal reserve, but it's painfully obvious. Perhaps there should be minimum capital reserves for bond insurers?

The point is that these risks were known, talked about, but the only thing the federal reserve did was ask the banks to start using paper to record these transactions.

And furthermore, the Fed could have simply raised interest rates when they started seeing the ridiculous amounts of homeowner debt, private debt, and leveraged loans that existed. These issues regularly showed up in their reports - graph upon graph showed huge spikes in credit. To put these spikes in perspective - from 1962 to 2001, the amount of homeowner debt expanded 48%. From 2001 to 2008, it expanded 36%. This is massive.

So in conclusion, the situation was known, and a remedy could have been as simple as raising interest rates - which would have been short term fix - to really figuring out a way to measure counterparty risk on these derivatives contracts which are really "financial weapons of mass destruction" which could have been quite possibly "devised by madmen"(thank you Warren Buffet). But yet no rating exists for, for example, the CDS counterparies in a contract in the form I have spoken about, on a per contract basis assuming all contracts, compared with the total assets of the company coupled with a risk assesment of that banks impact on the broader financial system if it were to take big losses on its derivatives contracts. This would have limited excess greatly by causing the fed to ring alarm bells on the risks to the financial system in the banks' faces, all while bringing the shadow banking system under control.

But the Fed did nothing but ask banks to start keeping it on paper, and in 2004, when the CDS market was ohh only 34 trillion. Surely, if you disagree with my perscriptions, you agree they could have definitely done more - that they are not helpless children who have no idea how our economy works. These are experts. Logic says they could easily have done something more than what they did.


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